Thursday, 13 June 2013

Caution – Windy Road Ahead

Trends in the stock
market are hard to spot at the best of times but upcoming changes to monetary
policy will add a few extra twists and turns.

Trying to work out the right time to buy or sell shares is like
driving at night with a busted headlight – only some of the road ahead is
visible and it is best to proceed with caution.
Evidence suggests that even the so-called experts struggle to negotiate
the markets better than anyone else. Everything
from nutty dictators in North Korea to the latest iPhone can throw the markets
into disarray. The task of investing in stocks
has been made even more difficult due to extra funds in the financial system
stemming from central banks everywhere printing money. The actions of the central banks has given
shares an extra boost but the resulting gains are expected to fade with more
cash likely to be less forthcoming as the global economy improves. With monetary policy now dominating movements
in the stock market, the prospect of changes by central banks are likely to
leave investors hanging on the edge of their seats.

The basic premise of shares in a company is that it entitles
the owner to a portion of the profits in that company. The value of shares will rise or fall depending
on the company’s ability to generate profits in the future. While profits also rely on circumstances at
each individual company, it is the state of the economy in which companies
operates that tends to dictate the direction of the stock market. So it may seem like somewhat of an anomaly
that some stock markets such as in the US are hitting record highs at a time
when the outlook for the global economy is so dismal.

The reason behind all this is monetary policy.

Central banks were quick to slash interest rates to close to
zero with the onset of the global financial crisis, but when the low interest
rates were having little effect in terms of the prescribed goal of boosting
lending, a new policy of quantitative easing was adopted. Central banks started to print money and use
this to buy bonds with the hope of making borrowing even cheaper. Yet in spite of all of these efforts, consumers
and companies have been stuck in a cautious mood and loathe to part with their
cash which they have stashed away instead.

The surplus funds end up being invested in assets such as
bonds and stocks. Bonds would be the
preferred investment due to being a safer bet amid these turbulent times, but
with central banks spending billions buying up bonds (which increases prices
and reduces returns), the meagre pay-out from bonds has seen funds flow instead
into the stock market. The extent of
these cash flows is such that it is vagaries of monetary policy that have come to
dominate the direction of share prices. The
underlying health of the economy only registers to the extent to which it has
an effect on the bond buying of central banks and has created a paradoxical
situation where bad news regarding the economy is good for shares as weak
economic growth translates to continued action by central banks.

The return of growth in the global economy may help to
cushion any weakness in share prices as the central banks wind down their
operations. In theory, steady economic
growth ensures that corporate profits increase over time, and thus, the value
of stocks is typically on an upward trend.
But with the possibility of ups and downs in the global economy, shares
may end up being overpriced depending on the extent of a potential correction
in the market due to the change in monetary policy. The potential for a correction in the stock
markets makes it tricky to call whether it is a good time to buy or sell with
the added uncertainty likely to make for a bumpy ride if you have the stomach
for it.